By Koh Gui Qing

NEW YORK (Reuters) - World stocks fell for a second day in a row on Tuesday while government bond yields and the U.S. dollar clung to multi-year highs, as surging inflation led investors to brace for what could be the largest U.S. interest rate hike in 28 years this week.

Surprisingly strong U.S. inflation data released Friday has fueled bets that the Federal Reserve must tighten monetary policy more aggressively to tame soaring prices. Fears that a steady series of rate rises could cause a recession walloped global equities on Monday.

Investors are betting with near certainty that the Fed will announce a 75-basis-point rate increase - the largest since November 1994 - at the end of its two-day policy meeting on Wednesday. It would be this year's third rate increase following two 50-basis-point hikes.

"A 75-basis-point increase is more consistent with the Fed's prior desire to 'expeditiously' raise rates to neutral," Goldman Sachs analysts said in a note to clients on Tuesday, adding that "a restrictive policy stance is necessary to tame inflation."

The analysts said they expect the Fed to raise rates by another 75 basis points in July, and predict that higher rates will likely bring on a recession in mid-2023.

Recession concerns and uncertainty around the outlook for rates weighed on stocks. The Dow Jones Industrial Average dropped 0.5% to a 16-1/2-month low, and the S&P 500 slipped 0.38%. The Nasdaq Composite bucked the trend and managed to eke out gains of 0.18%.

The S&P 500 tumbled into bear market territory on Monday after shedding more than 20% since a record close on Jan. 3.

The index now trades at a more attractive valuation of about 17 times its forward price-to-earnings ratio, according to data provider Datastream. That is roughly in line with its 10-year ratio average, and compares with a reading of more than 20 before the market correction.

MSCI's gauge of stocks around the world dropped 0.65% to levels last seen in November 2020, while a pan-European equity index slumped 1.26% to March 2020 lows.

Underscoring rising U.S. rate expectations, two-year Treasury yields rose to 3.4560%, the highest since November 2007, while 10-year Treasury yields struck an 11-year high of 3.4980%. [US/]

Markets now see the Fed's rate hike cycle peaking around 4%, a whopping 100 basis points above the 3% last month.

Euro zone government bond yields also hit multi-year highs, as spreads between core and periphery widened amid concerns about faster policy tightening by central banks. [GVD/EUR]